Wednesday, May 4, 2011

High-stakes and incentive distortions

One of the important underlying factors that generate incentive distortions and lead to rent-seeking behaviors is the presence of high-stakes facing agents. In response, agents search out channels to avoid complying with the rules of the game. Several, mostly unanticipated, incentive distortions arise from this urge. A market emerges to cater to this demand. And given the illegal nature of the activity and need being serviced, the market remains under-ground.

Here are some common examples of such high-stakes interventions that create incentive distortions

1. Increasing block tariffs (IBT) for water, electricity and other utilities where there is sharp jumps in tariffs across adjoining consumption-blocks. More or less the same principle applies to taxation slabs, where steep changes across adjacent slabs encourages tax payers, especially those at the margins, to under-report incomes/consumption so as to become eligible under the lower rate slab.

2. Harsh penalties for certain omissions, especially in commonplace activities, increases the incentives for individuals to under-report or hide their failures. This is especially true of sectors where quantification of actual outcomes is difficult or is easy to manipulate. Some of the commonest examples include penalties on teachers for poor academic performance of students and on doctors for unsatisfactory improvements in health indicators.

3. Similarly, very remunerative reward structures, especially those where executive compensation is tied to increased equity market valuations, too distorts incentives and encourages people over-report their achievements. Besides, it also results in excessive risk-taking among executives eager to benefit from the attraction of increasing returns that a bull market presents. This was a feature of the financial sector over the past decade or so and was a major contributor to the recent global financial crisis.

4. Benefit drops across at the margins. For example, income-based benefits, especially in economies with massive black markets, are extremely vulnerable to being pilfered and captured by ineligible beneficiaries. However, given the inevitability of means-tested programs, it may not be possible to completely dispense off with them. In fact, as I have blogged about earlier, such problems can be surmounted with a UID-based cash transfer schemes.

Public policy designed keeping in mind the aforementioned points can avoid or even eliminate some of the commonest incentive distortions that come in the way of effective implementation of development schemes and policies. Since sometimes they are inevitable, high-stakes policies like provision of employment opportunities, high investment decisions, etc should be subjected to much more rigorous monitoring than others.